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FRM Part II · FRM Exam Part II · Market-Driven Scenarios: An Approach for Plausible Scenario Construction

A risk team builds a scenario by shocking equity returns and then setting the conditional expected move in credit spreads using a linear relationship estimated from history. Which statement best describes the benefit of conditioning the other factors on the shocked factor?

Conditioning the unshocked factors on the shocked factor makes the scenario more plausible, because the other factors move in the way history suggests they typically do when the shocked factor moves. It does not guarantee a worst case or remove the need for covariance estimates.

  1. AIt guarantees the scenario will be the worst possible loss for the portfolio
  2. BIt makes the scenario more plausible by reflecting how the unshocked factors typically move when the shocked factor movesCorrect
  3. CIt eliminates the need to estimate any covariance information
  4. DIt ensures the scenario probability is exactly 1%

Explanation

Conditioning uses estimated relationships (for example covariances) to produce expected moves in other factors given the shock, so the scenario reflects realistic joint behavior. It does not guarantee a worst case, it requires covariance estimates, and it does not fix the probability at an arbitrary level.

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